Federal Income Tax Outlinepage 1 of 57

Federal Income Tax OutlinePage 1 of 57

Professor Brown

I. OVERVIEW & BASIC PRINCIPLES

Overview
Study & Practice of Law
Three Sections of Federal Income Tax:
Income;
Deductions; and
The merging of the two.
Brief History
Federal Income Tax is outlined in USC, Title 26.
The most recent edition is 1986.
The Tax Code is a revenue maker and a means used to curb or encourage certain behaviors.
Amendment Sixteen set the groundwork for Congress to impose a federal income tax.
The Amendment trumped the Apportionment Clause in Article 1, §8 & §9 because it would be impossible to impose.
Article 1, §8 gives Congress the power to levy taxes.
Courts consistently reject DPC and EPC taxpayer arguments
Reagan is responsible for dropping the tax rates. Clinton raised the tax rates. Currently, Bush is attempting to lower the tax rates again.
Tax Policy
This country’s federal income tax system is based upon Schanz-Haig-Simons. It takes into account both wealth and personal consumption.
Individual’s Income for a Year = Net increase in wealth plus the market value of consumption for personal purposes during the year, measured at year-end.
Arrived at indirectly by measuring: Current-year receipts minus business and investment deductions plus the increase in wealth or less the decrease in wealth.
The Federal Income Tax is progressive, not proportionate (flat tax).
Taxpayers in higher marginal brackets benefit less from additional income than taxpayers in lower marginal brackets, while taxpayers in higher marginal tax brackets benefit more from deductions than taxpayers in lower brackets.
FICA is a flat tax.
This country generally has a time-based system of reporting, not a transaction-based system of reporting. An exception is gains and losses derived from dealings in property.
Higher Tax Rates versus Lower Tax Rates:
Lower Rates (Conservatives)
Lower rates result in more “efficiency.”
Eg. Purchasing machinery and investing.
Favor a “Consumption Tax.”
An individual is only taxed on personal consumption; thus, the burden of a consumption tax falls hardest upon wage earners in part because they are not entitled to certain business-related deductions.
Eg. If an individual has income that is invested in machinery, it will not be taxed. However, if that individual is a worker, with no business expenditures, he will be taxed because he is consuming his wages.
Higher Rates (Liberals)
Higher rates result in more “equity.”
Standard of Living Principle and Ability to Pay Principle.
Utilitarianism is the philosophical tradition that postulates that policy should be directed toward increasing aggregate well-being (toward achieving the greatest happiness for the greatest number of people).
Eg. Poor people should pay less because of utility and marginal utility.
Favor an “Income Tax.”
An income tax is based on income.
This is our country’s system; however, this country is moving towards a consumption tax.
Bush Policy:
Rates are being lowered in all respects that help the wealthy, including business, investors, and high-income individuals. However, Bush portrays the package as assisting low-income individuals.
At the same time that wage earners are more heavily taxed, the wealthiest 1% of individual taxpayers are seeing significant gains.
Methods of Accounting: Cash versus Accrual
Cash. Actual receipt or payment of cash, and that is when reported.
Accrual. Legal right to receive or legal obligation to pay, and that is when reported.
Basic Principles
Gross Income
Three major terms that are determinative of tax base:
GI;
AGI; and
TI.
Follow these three steps along each problem.
SHS revisited: This is conceptually determinative of what is included in the tax base.
Individual’s Income for a Year = Net increase in wealth plus the market value of consumption for personal purposes during the year, measured at year-end.
The pressure is determining what is considered consumption for personal purposes, because business is excluded from the base.
§61(a). Gross income defined (all income from whatever source derived, included but not limited to…).
§62(a). Adjusted gross income defined (GI minus the following deductions).
The deductions listed under §62 are above-the-line deductions. Thus, an individual takes these deductions to get to AGI, and may take their personal exemption and either the standardized deduction or itemized deductions in addition to these above-the-line deductions.
§151. Personal exemption defined.
(d). Personal exemption amount. (c). Dependents defined.
Allowance for living to meet the most basic needs.
§63(c). Standard deduction defined.
Allowance for living to meet the most basic needs.
§63(a). Taxable income defined (GI minus the deductions allowed by this chapter (other than the standard deduction)).
§63. Determines what is deducted from GI to get to taxable income.
TI is the tax base and the tax base is what is subject to taxation.
Tax Liability is what each individuals owes after their tax is determined.
Problem 1.1.
Jorge (S)(No dependents)
Salary = 50,000
Dividend Income = 500
GI = 50,500
AGI = 50,500
TI = 50,500 - 500 (dividends) - 4,750 (standard) - 3,050 (personal) = 42,200
TL = 500*15% + 3,910 + (25%*(42,200 - 28,400) = 7,345
Earned Income Credit
§32. Money is transferred back to taxpayers whose income is below a certain level (“transfer payment”). Refundable credit, so a taxpayer does not have to pay this amount back to the IRS.
§32(c). In order to qualify for this section, the taxpayer must be at least 25 and not over 65. This section also defines qualifying children.
Problem 1.2(a).
Natasha (HH)(3 dependents)
Salary = 15,000
Standard = 7,000
Personal (x4) = 12,200
TI = Negative
Analysis.
(b)(1)(A): Get credit percentage by # of children.
40%
(b)(2)(A): Get earned income amount by # of children.
10,510
Credit percentage * earned income amount = maximum earned income credit.
40%*10,510 = 4,204
Limitation under (a)(2) (but see handout): Depending on amount of children, once earned income (earned income defined in (c)) hits a certain threshold amount, a phaseout begins, and if earned income hits complete amount, an earned income credit is not permitted.
Threshold Phaseout Amount = 13,730
Complete Phaseout Amount = 33,692
15,000 – 13,730 = 1,270
Pursuant (b)(1)(A), that amount time phaseout percentage.
1,270*21.06% = 267.
4,204 – 267 = 3,937 amount of earned income credit refund.
Problem 1.2(b).
Henry (HH)(3 dependents)
Salary = 16,000
Standard = 7,000
Personal (x4) = 12,200
TI = Negative.
Analysis.
Earned income credit starts at 4,204.
Phaseout:
16,000 – 13,730 = 2,270
2,270*21.06% = 478
4,204 – 478 = 3,276 amount of earned income credit refund.
Problem 1.2(c).
Natasha and Henry marry.
Salary = 31,000
Standard = 9,500
Personal (x8) = 24,400
TI = Negative.
Example of another marriage penalty. If Congress made the earned income credit more favorable for married people, they would have to tax something else more heavily to make up for the loss of revenue.
Note: Under §32(d), if Natasha and Henry were married, they cannot file separately just to get a more beneficial earned income credit.
Congress is trying to mitigate this penalty under §24.
There is a 1,000/child tax credit. But unlike §32, the §24 credit is not refundable pursuant to There is a 1,000/child tax credit. But unlike §32, the §24 credit is not refundable pursuant to §24(d).
Analysis.
Earned income credit begins at 4,204.
Phaseout:
31,000 – 14,730 = 16,270
16,720 * 21.06% = 3,426
4,204 – 3,426 = 778 amount of earned income credit refund.
Rates & the Taxpaying Unit, Family-Related Allowances & Progressive Rates
§1(a). Marital status is important because of the marriage penalty.
Once an individual gets over the 15% marginal rate, the tables have a built-in penalty.
If single, head of household, or married and filing separately, an individual can get more income in at a lower tax rate.
Exception: If one part of the couple is working and the other is not working, there is an incentive built into the table.
Problem 1.3.
Condolezza (M)(No dependents)
Receipts = 200,000
Dividends = 10,000
Salaries Paid = 100,000
Office Rent = 20,000
Depreciation = 40,000
Keogh Plan = 10,000
Deferred compensation plans are deducted to get to GI when they are distributed.
Standard = 9,500
Personal (x2) = 6,100
GI = 200,000 + 10,000 = 210,000
AGI = 210,000 – all business expenditures above = 40,000
TI = 40,000 – 9,500 – 6,100 = 24,400
Remove 10,000 dividends, for 14,400 to plug into tax table.
TL = 10,000*15% + tax rate answer = 2,960.
If Condolezza was single, her TL would have been 4,465.
§1(h). Net capital gains are pulled out from ordinary income before ordinary income is plugged into a table, and then the net capital gains are taxed at a more beneficial rate.
§2(b). Head of household defined.
§7703. State law dominates marriage law. If taxpayers are married on the last day of the financial year, they are married for tax purposes.
Effective Rate versus Marginal Rate.
Marginal Rate is the rate an individual pays for each additional dollar of income (the rate that an individual falls under in the tables).
Effective Rate is tax paid divided by taxable income.

II. “OUTER LIMITS” OF GROSS INCOME

Introduction
§61. States “all income from whatever source derived…” should be included in GI.
Thus, start with everything being included in GI (and tax base) and then determine if may be excluded or deducted, etc. pursuant to §61’s “except as otherwise provided…”
Glenshaw Glass (US 1955)
Rule. To be included in GI under §61, there must be three things:
Accession to wealth;
Clearly realized; and
Complete dominion.
Importance. If not enumerated under §61, it must pass this three prong test to be included in GI.
Windfalls & Property in Kind
Problem 2.1(a).
Winning new home on game show, or gambling winnings.
Analysis.
Included in GI because passes Glenshaw Glass, and falls under §74, and not §102 (thus falling under §61), because this is not a flat out gift, because as a contestant some work had to be put in to get the house.
§74. Prizes and awards part of GI.
§102. Gifts are excluded from GI.
§1001. The amount of the winnings is the AB so the taxpayer is not taxed twice.
Policy. Horizontal equity (similarly situated people should be treated the same).
Problem 2.1(b).
Tanya’s employer transfers to her title to land in exchange for services rendered.
Analysis.
§61(a). Treated as compensation for services and FMV included in GI.
Policy. Horizontal equity.
Problem 2.1(c).
Finds a new handbag worth $500.
Analysis.
Included in GI because Glenshaw Glass.
§1.61-14. Treasure trove constitutes GI when “undisputed possession.”
Note. If a taxpayer does not step forward and report, this is practically impossible for the IRS to track.
Realization of Income
Problem 2.1(f).
Martha leases land. Tenant improves by adding a building in 2003 with AB of 500,000. In 2028, transfers back to Martha, and the FMV of the building is 550,000. Martha’s AB in the land is 100,000. She sells later for 700,000 (100,000 allocated to land).
Analysis.
§109. Overruled Bruun. The value of the improvement not included in GI upon reversion. Thus, exclusionary section.
Policy for §109. If Martha taxpayers had to include improvements in GI upon reversion, they would have to sell the property to pay the tax and do not want to impede these transactions.
Thus, §109 is a great benefit to property owners because it almost acts as a tax shelter.
§1.61(8)(c). If the improvement was in lieu of rent, it would have been included in Martha’s GI.
§1019. No adjustment to AB either due to improvements.
§1011§1012. Thus, when Martha sells, she will recognize a 600,000 gain.
Blatt (US 1938)
Rule. Landlords do not include improvements in GI because appreciation is not realized yet.
Problem 2.1(g).
Chamique receives stock dividend (worth 1,000) in lieu of cash dividend at the company’s choice. Her AB in the original stock was 200. She sells after the stock dividend for 2,250 when the FMV was 2000.
Analysis.
§305(a). This section puts Eiser into the code. No GI recognized when receive the stock dividend.
(b) Exception. If the shareholder had an election to take cash dividend or stock dividend, must include in GI.
In this case, Chamique does not recognize any GI when she receives the stock dividend. When she sells, she recognized a gain of 2,250 – 200 = 2,050.
Thus, the gain is pretty much deferred until she sells.
Note. §1223(5). May be able to treat entirely as long term capital gain if can tack on new stock dividend onto the original stock purchased.
Commercial Bargain Purchases
Problem 2.1(d).
Purchase car worth 5,000 from a stranger for 4,500, or rebate.
Analysis.
“Arm’s length transaction (parties are not affiliated with each other in any regard),” so the 500 is not included in GI.
§1001. AB is 4,500, so the 500 pretty much deferred.
Policy. The 500 does not have the same utility as cash, and difficult for IRS to administer.
Problem 2.1(e).
Purchase car from employer worth 5,000 for 4,500. Employer purchased for 3,500.
Analysis.
No longer an arm’s length transaction, so the 500 is included in GI because treated like compensation for services.
Examples of non-arm’s length:
Employer/employee; and
Corporation/shareholder.
§1.61-2(d)(2)(i). Confirms this holding.
§102(c). Employer gifts must be included in GI.
Exception. Birthday gift.
AB = 5000
Barter Exchanges
Problem 2.1(h).
Brothers: Wedding cake (600) for will-drafting (600).
Analysis.
§102. When relatives or friends in barter exchange, assumed to be excludable. However, the parties must attempt to prove that there was “no reciprocity.” They did it for each other just out of love.
Rev Rule 79-24§1.61(2)(d)(1). When strangers, treated as compensation paid other than cash, so included in GI.
Imputed Income
The term “imputed income” refers to the gross annual fair rental value of consumer assets, such as residences, automobiles, and the like, or the value of self-provided services.
Not included in GI because impossible to administer and people should not be forced into the labor market. Also, can be seen as barter exchange and reciprocity from the family standpoint.
Economists think that imputed income should be taxed because for efficiency reasons.
Problem 2.1(i).
Thomas stays home and cares for the house and children when the wife works.
Analysis.
Not included in GI.
Again, this is actually beneficial for tax purposes to Thomas and his wife because of the Condoleeza problem.
Because this may provide incentive for taxpayers to stay at home, there are two sections that mitigate this incentive:
§21. Allows a credit.
§129. Allows a 5,000 credit when child-care is provided by employer.
Problem 2.1(j).
Benefits of owning a home.
Analysis.
Not included in GI, thus, an incentive is created for home ownership.
Again, economists hate this because they argue for market efficiency, some should invest in the stock market and not in homes.

III. IN-KIND CONSUMPTION BENEFITS

Introduction: Why Tax In-Kind Benefits (Fringe Benefits)?
§132(a). Lists fringe benefits that are excluded from GI. Why do we have this section?
Industry practices and employee expectations;
Convenience of employer;
Administrative convenience; and
Fairness/equity.
§132(j) Exception. Only for no additional cost service and employee discount, exclusion only applies to highly compensated employees if there is no discrimination (meaning, lower paid employees get the same benefits).
Employee Fringe Benefits
Problem 3.1.
Free parking for associates (FMV 220), but no free parking for secretaries.
Analysis.
There is no non-discrimination requirement for parking.
§132(f)(2)(B). May exclude up to 190/month for parking. So, must include 30/month in GI.
§132(f)(2)(A). Transit pass up to 100/month.
Note. (f) only applies to commuting expenses, not business travel.
Policy. Industry practice and employer convenience.
Problem 3.2.
Regular price of 750. Marked down to 600 for customers. Maida with employee discount purchased for 420. The gross profit percentage in the line of business is 25%.
Analysis.
§132(c)(4). Must be qualified property or service to get an employee discount. For that to occur, must be property (other than real or personal property held for investment) or services which are offered in the ordinary course of the line of business of the employer in which the employee is performing services.
(c)(2). Gross profit percentage is (A)(i)/(A)(ii).
(c)(1)(B). This problem has a product, not a service. If a service is involved, the discount cannot exceed 20% of the price at which the services are being offered by the employer to customers.
(c)(3).
600 (price offered to customers)*25% = 150.
600 – 420 = 180.
180 – 150 = 30 included in GI.
Policy. Industry practice and employer convenience.
Problem 3.3.
Free coffee and donuts every Wednesday morning, or photocopying or phone calls or late night dinners or cab rides when working late.
Analysis.
§132(a). Not included in GI, because de minimus. To be de minimus, must meet to criteria:
Minor value; and
Too much trouble to keep track of.
Policy. Administrative convenience.
§119. Does not fall under here because to fall under this section, the employees must need the food to perform their job.
Problem 3.4.
Fred accumulates frequent flyer miles when on business trips that are deductible under §162. He uses these miles for other client related trips.
Analysis.
§132(d) or Gotcher. Working condition fringe, meaning, if employee paid for it, and was able to exclude it under §162, or §167, it is excluded under §132 if the employer pays for it.
If primarily benefiting employer, than it is excluded from GI. Thus, excludable by Fred.
Note. Even if Fred used these miles for personal use, they would not be included in GI because it is impossible for IRS to administer. Actually, the IRS put out a Notice, stating that personal use of frequent flyer miles should be included in GI, but that they are delaying enforcement because they don’t know how to enforce.
Problem 3.5.
Fred’s wife accompanies on trip for personal purposes and the company reimburses for that.
Analysis.
§132(d). Must include her portion of the trip in Fred’s GI because Fred cannot deduct her trip under §162 or §167. See also Gotcher (wife’s trip value included in GI).
Gotcher. The amount is included in Fred’s GI, not the wife’s GI because it is treated as a gift to the wife.
§274(m)(3). No deduction for spouse travel.
Meals & Lodging
Problem 3.6.
Firefighters work three day on, and three day off. On their days on, they are provided free room and board.
Analysis.
§119(a). Not included in GI because requirements for meals and lodging are met.
For meals to be excluded, two requirements must be met:
For convenience of the employer; and
Furnished on business premises.
§1.119-1(b). For lodging to be excluded, three requirements must be met:
Furnished on business premises of employer;
Furnished for convenience of the employer; and
The employee is required to accept such lodging as a condition of his employment.
Example of who would qualify:
Superintendent of building.
Example of who would not qualify:
Professor given housing because requirement three missing.
§119(d) Exception.